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The Fed's fight against inflation becomes more complicated as the cost of services rises

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Persistently high U.S. inflation will be hard to contain after taking root in the economy’s service sector, economists are warning, suggesting the Federal Reserve will be forced to push through with further interest rate hikes in 2023.

After a year of skyrocketing consumer prices, the US inflation rate is poised to drop sharply next year. But many economists warn that underlying pressures will keep it at levels well above what the Fed finds palatable.

“The risk of confusion here is that on the one hand this will sound like great progress and it will look like maybe we can relax,” said Jean Boivin, a former Bank of Canada vice president who now runs the BlackRock Investment Institute. “But these numbers at the end of the year will not come close to the CEP of [what] the Fed will be comfortable.”

The US central bank has aggressively raised interest rates this year in a bid to end high inflation. But their task is made more complicated by the divergence between price trends for goods and services.

Inflation-linked everyday goods such as furniture, used cars and home appliances are in decline. Prices for these items skyrocketed at the start of the pandemic as demand surged and manufacturing and shipping ground to a halt. Recent data suggest the trend has started to reverse and is likely to continue into 2023 as retailers reduce bloated inventories.

Housing costs are also likely to cool, economists say. Rising mortgage rates linked to the Fed’s rate hikes have brought home prices down. New rentals for rental properties are down from recent peaks, with asking rents posting the biggest monthly drop in the seven years since real estate Zillow started tracking data.

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Taken together, most Fed officials expect the consumer spending price index – once volatile food and energy costs are eliminated – to decline to an annual rate of 3.5% next year. Economists polled by Bloomberg forecast that PCE core inflation will moderate to around 3% in the fourth quarter of next year.

Both projections remain well above the Fed’s 2% target. In November, the core PCE index rose 4.7% year-on-year, according to data released on Friday, slowing from a peak of 5.4% earlier this year but above the Fed’s target.

Offsetting declining asset inflation are the costs of dining out, getting haircuts, commuting and other service sector activities – a dynamic that Fed Chair Jay Powell warned about in his late 2022 press conference. .

“Goods inflation has changed very quickly now, after not changing for a year and a half,” he said after the Fed’s December policy meeting, where the central bank slowed the pace of interest rate hikes and raised its rate. base interest. to a new target of 4.25% to 4.5%. “But there is an expectation that services inflation will not come down so quickly, so we will have to stay at that [and] we may have to raise rates to get where we want to go.

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The persistence of services inflation depends mainly on the labor market. Amid worker shortages and strong consumer demand, employers have had to raise wages and benefits to keep pace. Compared with November of last year, wages were up 6.4%, data from the Atlanta Fed shows.

Fed officials have conceded that their efforts to curb inflation will involve job losses, but say a recession is avoidable. Most policymakers expect the economy to grow just 0.5% next year and the jobless rate to rise by nearly a percentage point to 4.6%.

“What they’re trying to do is cool inflation faster than wages,” Diane Swonk, chief economist at KPMG, said of the Fed.

Swonk expects the economy to slip into a recession next year, while inflation drops to just under 3% by the end of 2023. The prospect of being blamed for job losses puts the Fed “in that horrible position of having to look like it’s against the labor market”, he said.

Officials say they can control inflation by raising the federal funds benchmark rate to between 5% and 5.25% next year and holding that level through at least 2024 – a view that is at odds with current market prices, which suggests the bank won’t have to raise its benchmark rate above 5% and will make about two rate cuts by the end of next year.

Powell also warned that the Fed may need to be even more aggressive if the data don’t cooperate, given its unwavering commitment to curb inflation. One concern is the potential impact of China reversing its Covid-zero policy, which some economists warn could trigger another round of hikes in commodity prices.

“Without price stability, you have nothing,” said Stephen Cecchetti, an economist at Brandeis University, who previously headed the economics and monetary department at the Bank for International Settlements. “You don’t have general economic stability and prosperity. You lack financial stability. You just get chaos.